- 41. Deferred income liabilities
- 42. Deferred tax liabilities
- 43. Other liabilities
- 44. Related party transactions
- 45. Contingent liabilities, guarantees and indemnities
- 46. Commitments
- 47. Subsidiaries
- 48. Associates and joint ventures
- 49. Goodwill resulting from acquisitions
- 50. Management of capital resources
- 51. Risk Management and Control
51. RISK MANAGEMENT AND CONTROL
The sections that follow describe the Group’s approach to risk management. The first section deals with the overall approach, applicable to all risks. It is followed by a detailed review of risks within the Group’s key businesses.
Risk management objectives
The Group’s primary objective in undertaking risk management activity is to minimise its exposure to unexpected financial loss and limit the potential for deviation from anticipated outcomes.
Risk management approach
A significant part of the Group’s business involves the acceptance and management of risk. The Group is exposed to insurance, market, credit, liquidity and operational risks and operates a formal risk management framework to ensure that all significant risks are identified and managed. The risk factors mentioned below should not be regarded as a complete and comprehensive statement of all potential risks and uncertainties.
Insurance risk: Insurance risk is the risk arising from higher claims being experienced than anticipated.
Market risk: Market risk is the risk arising from fluctuations in interest rates, exchange rates, share prices and other relevant market prices.
Credit risk: Credit risk is the risk of loss if another party fails to perform its financial obligations to the Group.
Liquidity risk: Liquidity risk is the risk that the Group, though solvent, does not have sufficient financial resources available to enable it to meet its obligations as they fall due, or can only secure them at excessive cost.
Operational risk: Operational risk is the risk arising from inadequate or failed internal processes, people and systems, or from external events.
Risk framework
Overall responsibility for the management of the Group’s exposure to risk is vested in the Group Board. To support it in this role, a risk framework is in place comprising a structure of formal committees, risk assessment and reporting processes and risk review functions. The framework provides assurance that risks are being appropriately identified and managed and that an independent assessment of risks is being performed.
Oversight of the risk management framework is performed on behalf of the Group Board by its sub-committee, the Group Risk and Compliance Committee (GRCC). The GRCC is supported in this role by the following sub-committees:
Capital Committee: The Capital Committee assesses the capital requirements (including the risk based capital requirements) of the Group; monitors the sources of capital available to meet these requirements; oversees the allocation of capital to firms; and monitors at a Group level a number of performance and capital measures.
Counterparty Credit Committee: The Committee has oversight of counterparty credit risk across the Group, sets the limits for the Group’s exposure to any single counterparty failure and manages exposures within these limits.
UK Asset and Liability Committee: The Committee has oversight of the management of market and liquidity risks arising within Legal & General Assurance Society Limited (Society), and its subsidiaries Legal & General Pensions Limited (LGP) and Legal & General Insurance Limited (LGI).
UK Pricing and Insurance Risk Committee: The Committee has oversight of the management of insurance risk arising within Society, LGP and LGI. Oversight of the management of insurance risks arising within the Group’s overseas subsidiaries is performed by the boards of the local holding companies, which report directly to the GRCC.
Group Operational Risk Assessment Committee: The Committee has oversight of specific aspects of the Group’s operational risk, particularly issues which are common across the Group, and seeks to ensure consistency in approaches to operational risk management. In addition, Risk and Compliance Committees (RCCs) are in place for each of the Group’s main operational businesses. These committees are predominantly responsible for reviewing the management of operational risks and compliance with regulation.
The local holding companies of the overseas subsidiaries have established RCCs to cover their trading subsidiaries. The Boards of overseas firms are responsible for ensuring appropriate processes are in place for the management of risk exposures. The GRCC receives reports from the RCCs of each overseas firm to confirm that risks remain acceptable.
Methods used to monitor and assess risk exposures
A continuous Groupwide process is in place formally identifying, evaluating and managing significant risks to the achievement of the Group’s objectives. A standard approach is used to assess risks. Senior management and the risk review functions review the output of the assessments. A Groupwide risk assessment process is used to provide determination of key risks within the Group reported to the GRCC.
Group and firm level risk review functions provide oversight of the risk management processes within the Group. A central risk function is responsible for setting the risk management framework and standards. Risk review functions in each of the business operating units manage the framework in line with these standards. Their responsibilities include the evaluation of changes in the business operating environment and business processes, the assessment of these changes on risks to the business and the monitoring of the mitigating actions. The risk review functions also ensure that RCCs are provided with meaningful risk reports and that there is appropriate information to assess risk issues.
Management of risks
The Group seeks to manage its exposures to risk through control techniques so as to ensure that the residual risk exposures are within acceptable tolerances agreed by the Board. The key control techniques for the major categories of risk exposure are summarised in the following sections.
Insurance risk
Insurance risk is implicit in the Group’s insurance business and arises as a consequence of the type and volume of new business written and the concentration of risk in particular policies or groups of policies subject to the same risks. A detailed review of the Group’s inherent residual risks associated with insurance products is included in the UK life and pensions section of the notes. Insurance risk is managed using the following techniques:
Policies and delegated authorities for underwriting, pricing and reinsurance
Pricing is based on assumptions, such as mortality and persistency, which have regard to past experience and to trends. Insurance exposures are limited through reinsurance. Overall, the Group seeks to be conservative in its acceptance of insurance risks by establishing strict underwriting criteria and limits. The underwriting policy is clearly documented, setting out risks which are unacceptable and the terms applicable for non-standard risks.
Reinsurance is used to reduce potential loss to the Group from individual large risks and catastrophic events. It may also be used to manage capital or to provide access to specialist underwriting expertise. The Group makes extensive use of reinsurance for its UK individual protection business, placing a proportion of all risks meeting prescribed criteria. The Group has also entered into external reinsurance arrangements, the primary effect of which is to reduce the capital requirements associated with this business.
The principal General insurance reinsurances are excess of loss catastrophe treaties, under which the cost of claims from a weather event, in excess of an agreed retention level, is recovered from reinsurers.
Reserving policy
All subsidiaries writing insurance business have a documented reserving policy setting out the basis on which liabilities are to be determined using statistical analysis and actuarial experience. Policies for each subsidiary are in line with locally established actuarial techniques, relevant regulation and legislation. Further details of the assumption setting process are included in Note 37.
Market Risk
The Group is exposed to market risk as a consequence of fluctuations in values or returns on assets and liabilities, which are influenced by one or more external factors, including changes in specified interest rates, financial instrument prices, foreign exchange rates, and indices of prices or rates. Significant areas where the Group is exposed to these risks are:
- assets backing insurance and investment contracts other than linked contracts
- assets and liabilities denominated in foreign currencies; and
- other financial assets and liabilities
The Group manages market risk using the following methods:
Asset liability matching
The Group manages its assets and liabilities in accordance with relevant regulatory requirements, reflecting the differing types of liabilities it has in each business.
For business such as immediate annuities, which are sensitive to interest rate risk, cash flow analysis is used to create a portfolio of fixed income securities, the value of which changes in line with the value of liabilities when interest rates change. This type of analysis helps protect profits from changing interest rates. Interest rate risk cannot be completely eliminated, due to the nature of the liabilities and early redemption options contained in the assets.
For businesses where a range of asset types, including equity and property, are held to meet liabilities, the Group uses stochastic models to assess the impact of a range of future return scenarios on investment values and associated liabilities. This allows the Group to devise an investment and with-profits policyholder bonus strategy which optimises returns to its policyholders over time, whilst limiting the capital requirements associated with these businesses. The Group uses this method extensively in connection with its UK with-profits business.
Derivatives
The Group uses derivatives to reduce market risk. The most widely used derivatives are exchange traded equity futures and swaps. The Group may use futures to facilitate efficient asset allocation. In addition, derivatives are used to improve asset liability matching and to manage interest rate, foreign exchange and inflation risks. It is the Group’s policy that amounts at risk through derivative transactions are covered by cash or corresponding assets and that swaps are collateralised to reduce counterparty exposure.
Interest rate risk
Interest rate risk is the risk that the Group is exposed to lower returns or loss as a direct or indirect result of fluctuations in the value of, or income from, specific assets arising from changes in underlying interest rates.
The Group is exposed to interest rate risk on the investment portfolio it maintains to meet the obligations and commitments under its non-linked insurance and investment contracts, in that the proceeds from the assets may not be sufficient to meet the Group’s obligations to policyholders.
To mitigate the risk that guarantees and commitments are not met, the Group purchases financial instruments, which broadly match the expected non-participating policy benefits payable, by their nature and term. The composition of the investment portfolio is governed by the nature of the insurance or savings liabilities, the expected rate of return applicable on each class of asset and the capital available to meet the price fluctuations for each asset class, relative to the liabilities they support. Additionally, fluctuations in interest rates will vary the repayments on variable rate debt issued by the Group (Note 38).
Table 3 summarises the exposure of the Group’s assets to changes in interest rates. Financial assets which are not directly exposed to interest rate risk (such as linked assets, equities, other debtors) have not been included. Asset liability matching significantly reduces the Group’s exposure to interest rate risk. The expected cash outflows on insurance contract liabilities are shown in Note 33.
| Within 1 year | 1–5 years | 5–15 years | 15–25 years | Over 25 years | Total | ||||||
| As at 31 December 2006 | £m | %1 | £m | %1 | £m | %1 | £m | %1 | £m | %1 | £m |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Fixed rate securities | 218 | – | 1,773 | 5.4 | 8,912 | 5.2 | 6,402 | 5.1 | 6,126 | 5.3 | 23,431 |
| Variable rate securities | 192 | 5.4 | 660 | 5.1 | 285 | 4.9 | 15 | 4.6 | 167 | 5.1 | 1,319 |
| Loans and receivables | 178 | 4.1 | 17 | 4.5 | 12 | 6.8 | 5 | 6.4 | 31 | 6.8 | 243 |
| Interest rate swaps | – | – | – | 6.9 | (85) | 5.5 | – | 1.7 | 3 | 3.1 | (82) |
| Cash and cash equivalents | 2,079 | 4.8 | – | – | – | – | – | – | – | – | 2,079 |
| Investments exposed to interest rate risk | 2,667 | 2,450 | 9,124 | 6,422 | 6,327 | 26,990 | |||||
| Within 1 year | 1–5 years | 5–15 years | 15–25 years | Over 25 years | Total | ||||||
| As at 31 December 2005 | £m | %1 | £m | %1 | £m | %1 | £m | %1 | £m | %1 | £m |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Fixed rate securities | 388 | 3.9 | 1,264 | 4.8 | 7,429 | 4.8 | 8,675 | 4.6 | 5,690 | 5.0 | 23,446 |
| Variable rate securities | 198 | 4.8 | 790 | 4.5 | 222 | 4.8 | 38 | 5.3 | 102 | 4.9 | 1,350 |
| Loans and receivables | 144 | 4.5 | 15 | 4.5 | 5 | 6.2 | 12 | 5.9 | 39 | 5.9 | 215 |
| Interest rate swaps | – | – | – | – | (88) | – | – | – | 6 | – | (82) |
| Cash and cash equivalents | 1,838 | 4.4 | – | – | – | – | – | – | – | – | 1,838 |
| Investments exposed to interest rate risk | 2,568 | 2,069 | 7,568 | 8,725 | 5,837 | 26,767 | |||||
- 1
- Weighted average effective interest rate.
Both fixed rate financial assets and variable rate securities are categorised by maturity dates.
Currency risk
The Group manages its currency risk exposure in the following way:
- In respect of long term business assets and liabilities denominated in non-sterling currencies, the Group protects its exposure to exchange rate fluctuations by backing obligations with investments in the same currency.
- Balance sheet foreign exchange currency translation exposure in respect of the Group’s international subsidiaries is actively managed in accordance with a policy, agreed by the Group Board, which allows between 25% and 75% of net foreign currency assets to be hedged through the use of derivatives.
Table 4 summarises the Group’s exposure to foreign currency exchange risk, in sterling. Non—linked assets and liabilities are reported in their underlying currency.
| As at 31 December 2006 | Sterling 2006 £m |
Euro 2006 £m |
US
Dollar 2006 £m |
Japanese
Yen 2006 £m |
Other
2006 £m |
Linked 2006 £m |
Total 2006 £m |
|---|---|---|---|---|---|---|---|
| Assets | |||||||
| Investment in associates | 16 | – | – | – | – | – | 16 |
| Plant and equipment | 40 | 2 | 1 | – | – | – | 43 |
| Investments | 35,693 | 2,854 | 2,339 | 643 | 890 | 170,793 | 213,212 |
| Purchased interests in long term business | 7 | – | 16 | – | – | – | 23 |
| Other operational assets | 3,001 | 200 | 846 | – | 1 | 523 | 4,571 |
| Total assets | 38,757 | 3,056 | 3,202 | 643 | 891 | 171,316 | 217,865 |
| Liabilities | |||||||
| Subordinated borrowings | 429 | 389 | – | – | – | – | 818 |
| Participating contract liabilities | 20,448 | 1,273 | – | – | – | 227 | 21,948 |
| Non-participating contract liabilities | 14,121 | 375 | 1,149 | – | 1 | 167,972 | 183,618 |
| Senior borrowings | 990 | 121 | 496 | – | – | – | 1,607 |
| Provisions | 566 | 2 | – | – | – | – | 568 |
| Deferred liabilities | 715 | 21 | 158 | – | – | – | 894 |
| Creditors | 644 | 168 | 466 | – | 1 | 490 | 1,769 |
| Net asset value attributable to unitholders | – | – | – | – | – | 804 | 804 |
| Total liabilities | 37,913 | 2,349 | 2,269 | – | 2 | 169,493 | 212,026 |
| As at 31 December 2005 | Sterling 2005 £m |
Euro 2005 £m |
US
Dollar 2005 £m |
Japanese
Yen 2005 £m |
Other 2005 £m |
Linked 2005 £m |
Total 2005 £m |
|---|---|---|---|---|---|---|---|
| Assets | |||||||
| Investment in associates | 16 | – | – | – | – | – | 16 |
| Plant and equipment | 28 | 2 | 2 | – | – | – | 32 |
| Investments | 37,426 | 2,352 | 2,476 | 809 | 804 | 142,530 | 186,397 |
| Purchased interests in long term business | 10 | – | 15 | – | – | – | 25 |
| Other operational assets | 3,860 | 202 | 913 | – | 1 | 419 | 5,395 |
| Total assets | 41,340 | 2,556 | 3,406 | 809 | 805 | 142,949 | 191,865 |
| Liabilities | |||||||
| Subordinated borrowings | 415 | – | – | – | – | – | 415 |
| Participating contract liabilities | 20,767 | 1,203 | – | – | – | 201 | 22,171 |
| Non-participating contract liabilities | 15,921 | 350 | 1,262 | – | 2 | 141,421 | 158,956 |
| Senior borrowings | 1,215 | 110 | 308 | – | 1 | – | 1,634 |
| Provisions | 578 | 3 | 1 | – | – | – | 582 |
| Deferred liabilities | 656 | 32 | 155 | – | – | – | 843 |
| Creditors | 867 | 128 | 121 | – | 3 | 381 | 1,500 |
| Net asset value attributable to unit holders | – | – | – | – | – | 828 | 828 |
| Total liabilities | 40,419 | 1,826 | 1,847 | – | 6 | 142,831 | 186,929 |
Other price risk
Other price risk is the risk that the fair value of future cash flows of a financial instrument will fluctuate because of changes in market prices other than those arising from interest rate risk or currency risk. These changes may be as a result of features of the individual instrument, its issuer or factors affecting all similar financial instruments traded in the market.
The Group controls its exposure to geographic price risks by using internal country credit ratings. These ratings are based on macroeconomic data and key qualitative indicators. The latter take into account economic, social and political environments. Table 5 indicates the Group’s exposure to different equity markets around the world. Linked equity investments are excluded from the table as the risk is retained by the policyholder.
| 2006 £m |
2005 £m |
|
|---|---|---|
| UK | 8,557 | 8,567 |
| North America | 441 | 366 |
| Europe | 1,027 | 986 |
| Japan | 619 | 741 |
| Asia Pacific | 695 | 611 |
| Other | 35 | 39 |
| Listed equities | 11,374 | 11,310 |
| Unlisted UK equities | 201 | 203 |
| Holdings in unit trusts | 1,267 | 1,381 |
| Total equities | 12,842 | 12,894 |
The Group holds non-linked commercial property investments totalling £3,751m (2005: £3,653m), of which £3,729m (2005: £3,587m) are located in the UK.
Credit risk
Credit risk is the risk that the Group is exposed to loss if another party fails to perform its financial obligations to the Group.
Significant areas where the Group is exposed to credit risk are:
- The Group holds corporate bonds to back part of its insurance liabilities. Significant exposures are managed by the application of concentration limits, with allowance being made in the actuarial valuation of the insurance liabilities for possible defaults.
- The Group limits its exposure to insurance risk by ceding part of the risks it assumes to the reinsurance market. To limit the risk of reinsurer default the Group operates a credit rating policy when arranging cover. When selecting new reinsurance partners the Group considers only companies which have a minimum credit rating equivalent to A from Standard & Poor’s and imposes limits on the level of exposure to any individual reinsurer.
Aggregate counterparty exposures are regularly monitored both at an individual subsidiary level and on a Groupwide basis.
The credit profile of the Group’s assets exposed to credit risk is shown in Table 6. The credit rating bands are provided by independent rating agencies.
| As at 31 December 2006 | AAA £m |
AA £m |
A £m |
BBB £m |
BB and below £m |
Unrated £m |
Total £m |
|---|---|---|---|---|---|---|---|
| Government securities | 4,790 | 66 | 79 | – | – | 95 | 5,030 |
| Other fixed rate securities | 5,333 | 2,621 | 6,706 | 2,166 | 87 | 1,488 | 18,401 |
| Variable rate securities | 534 | 111 | 232 | – | – | 49 | 926 |
| Mortgage backed securities | 388 | – | – | – | – | 5 | 393 |
| Other investments | 17 | 66 | 87 | – | – | 58 | 228 |
| Derivative assets | 14 | 24 | 2 | – | – | – | 40 |
| Cash equivalents | 376 | 101 | 1,459 | – | – | 6 | 1,942 |
| Financial assets | 11,452 | 2,989 | 8,565 | 2,166 | 87 | 1,701 | 26,960 |
| Reinsurance assets | 7 | 978 | 108 | 2 | 317 | 106 | 1,518 |
| 11,459 | 3,967 | 8,673 | 2,168 | 404 | 1,807 | 28,478 |
| As at 31 December 2005 | AAA £m |
AA £m |
A £m |
BBB £m |
BB and below £m |
Unrated £m |
Total £m |
|---|---|---|---|---|---|---|---|
| Government securities | 4,826 | 205 | 28 | – | – | – | 5,059 |
| Other fixed rate securities | 5,216 | 2,623 | 6,893 | 2,573 | 12 | 1,070 | 18,387 |
| Variable rate securities | 433 | 93 | 371 | 1 | – | 42 | 940 |
| Mortgage backed securities | 385 | – | 6 | – | – | 19 | 410 |
| Other investments | – | – | 142 | – | – | 73 | 215 |
| Derivative assets | – | 15 | 11 | – | – | – | 26 |
| Cash equivalents | 293 | 130 | 1,147 | – | – | 142 | 1,712 |
| Financial assets | 11,153 | 3,066 | 8,598 | 2,574 | 12 | 1,346 | 26,749 |
| Reinsurance assets | – | 1,528 | 1,071 | 25 | 9 | 299 | 2,932 |
| 11,153 | 4,594 | 9,669 | 2,599 | 21 | 1,645 | 29,681 |
Liquidity risk
Liquidity risk is the risk that the Group, though solvent, either does not have sufficient financial resources available to enable it to meet its obligations as they fall due or can secure them only at excessive cost. The Group’s treasury function is responsible for managing the Group’s banking relationships, capital raising activities, overall cash and liquidity position and the payment of dividends. The Group seeks to manage funds and liquidity requirements on a pooled basis and to ensure the Group maintains sufficient liquid assets and standby facilities to meet a prudent estimate of its net cash outflows. In addition it ensures that, even under adverse conditions, the Group has access to the funds necessary to cover surrenders, withdrawals and maturing liabilities. In practice, most of the Group’s invested assets are marketable securities. This, combined with the fact that a large proportion of the liabilities contain discretionary surrender values or surrender charges, reduces the liquidity risk. The Group has in place a £1bn, five year syndicated borrowing facility which provides flexibility in the management of the Group’s liquidity.
Operational risk
Operational risk is the potential for loss resulting from inadequate or failed internal processes, people and systems, or from external events. There are a number of headings under which operational risk and its management across the Group can be considered. Identified control issues are escalated to business unit RCCs.
Internal process failure
The Group is exposed to the risk of loss from failure of the internal processes with which it transacts its business. Each subsidiary is responsible for ensuring the adequacy of the controls over its processes and regular reviews are undertaken of their appropriateness and effectiveness. All business managers are required to confirm regularly the adequacy of controls from these reviews to business unit RCCs, the GRCC and the Group Audit Committee. Significant control issues which business areas identify are escalated to business unit RCCs, which oversee their resolution.
People
The Group is potentially exposed to the risk of loss from inappropriate actions by its staff. The risk is actively managed by business management and human resource (HR) functions. Recruitment is managed centrally by HR functions, and all new recruits undergo a formal induction programme. All employees have job descriptions setting out their accountabilities and reporting lines, and are appraised annually in accordance with agreed performance management frameworks. Employees in regulated subsidiaries are provided with appropriate training to enable them to meet the relevant regulatory requirements. Risks relating to health and safety and other legislation are managed through the provision of relevant training to all staff.
Outsourcing
The Group is potentially exposed to the actions or failure of suppliers contracted to provide services on an outsourced basis, although the Group is not a significant user of such services. The required minimum standards of control for outsourced arrangements are set out in the Group’s outsourcing and key supplier policy. Compliance with this policy is monitored by business management and adherence is reported through the regular controls confirmation process undertaken across the Group.
Legal
Legal risk is the risk of loss from unclear or deficient product documentation; inadequate documentation in support of material contracts such as reassurance treaties; the incorrect interpretation of changes in legislation; employment related disputes and claims; and commercial disputes with suppliers. The risks are actively managed through the Group Legal Risk framework, which defines minimum standards of control to be applied to minimise the risk of loss.
Compliance
Compliance risk within the Group relates to the risk of non-adherence to legislative requirements, regulations and internal policies and procedures. Responsibility for ensuring adherence to relevant legal and regulatory requirements is vested in individual business managers. They are supported, where appropriate, by business standards functions which assess and confirm that business processes conform to these requirements. A Group compliance function has oversight of the Group’s compliance with regulatory requirements and standards, providing policy advice and guidance and oversight of compliance arrangements and responsibilities.
Event
Event risk relates to the potential for loss arising from external significant events such as terrorism, financial crisis, major changes in fiscal systems or disaster. Typically, such events have a low likelihood of occurrence, a material impact and can be difficult to prevent. The Group’s risk mitigation focuses on minimising the business disruption and potential financial loss which may ensue from such an event. This includes maintaining a framework for the management of major incidents, the maintenance and regular testing of detailed business, technical and location recovery plans and the provision of insurance cover for the loss of buildings, contents and information technology (IT) systems and for the increased cost of working in the event of business disruption.
Fraud
The Group is exposed to the risk of internal fraud, claim related fraud, and external action by third parties. The risk of internal fraud is managed through a number of processes including the screening of staff at recruitment, segregation of duties and whistle-blowing policies. The activities of internal audit also act to counter the risk. Claims related fraud is managed by ensuring business processes are designed to fully validate claims and ensure that only bona fide claims are settled. Anti—fraud techniques are regularly updated to mitigate risks and emerging threats.
Technology
The Group places a high degree of reliance on IT in its business activities. The failure of IT systems could potentially expose the Group to significant business disruption and loss. To mitigate this risk, standards and methodologies for developing, testing and operating IT systems are maintained. There is a centralised management for development activity and production systems to ensure consistency and adherence to standards. Disaster recovery facilities enable IT operations to be conducted at remote locations in the event of the loss of computer facilities at a principal office site. All records are remotely backed up and computer suites are equipped with alternative power sources.
UK life and pensions
UK life and pensions products are structured as either participating products, or non-participating products, including annuities in payment and unit linked products. The level of shareholders’ interest in the value of policies and their share of the related profit or loss varies depending upon the contract structure.
Non-participating contracts
Profits from non-participating business accrue solely to shareholders. Such business is written mainly in the non profit part of the Society LTF. In addition, there is some non-participating business in the with-profits part of the Society LTF.
Protection business (individual and group)
The Group offers protection products which provide mortality or morbidity benefits and may include health, disability, critical illness and accident benefits. These additional benefits are commonly used as supplements to main life policies but can also be sold separately. The benefit amounts would usually be specified in the policy terms. Some sickness benefits are sold to cover the policyholder’s mortgage repayments and are linked to the prevailing mortgage interest rates. In addition to these benefits, some contracts may guarantee premium rates, provide guaranteed insurability benefits and offer policyholders conversion options.
Life savings business
A range of contracts is offered in a variety of different forms to meet customers’ long term savings objectives. Policyholders may choose to include a number of protection benefits in their savings contracts. Typically, any guarantees under the contract would only apply on maturity or earlier death. On certain older contracts there may be provisions guaranteeing surrender benefits. Savings contracts may or may not guarantee policyholders an investment return. Where the return is guaranteed, the Group may be exposed to interest rate risk with respect to the backing assets.
Pensions (individual and corporate)
These are long term savings contracts through which policyholders accumulate pension benefits. Some older contracts contain a basic guaranteed benefit expressed as an amount of pension payable or a guaranteed annuity option which exposes the Group to interest rate and longevity risk. These guarantees become more costly during periods when interest rates are low or when annuitant mortality improves faster than expected. The ultimate cost will also depend on the take-up rate of any option and the final form of annuity selected by the policyholder.
Other options provided by these contracts include an open market option on maturity, early retirement and late retirement. The Group would generally have discretion over the terms on which these options are offered.
Annuities
Deferred and immediate annuity contracts are offered. Immediate annuities provide a regular income stream to the policyholder, purchased with a lump sum investment, where the income stream starts immediately after the purchase. The income stream from a deferred annuity is delayed until a specified future date. Bulk annuities are also offered, where the Group manages the assets and accepts the liabilities of a company pension scheme or a life fund.
Non-participating deferred annuities written by the Group do not contain guaranteed cash options.
Annuity products provide guaranteed income for a specified time, usually the life of the policyholder, in exchange for a lump sum capital payment. No surrender value is available under any of these products. The primary risks to the Group from annuity products are therefore mortality improvements and investment risk.
There is a block of immediate and deferred annuities within the UK non profit business with benefits linked to changes in the Retail Price Index (RPI), but with contractual maximum or minimum increases. In particular, most of these annuities have a provision that the annuity will not reduce if RPI falls. The total of such annuities in payment at 31 December 2006 was £136m (2005: £190m). Thus, 1% negative inflation, which was reversed in the following year would result in a guarantee cost of approximately £1m (2005: £2m). Negative inflation sustained over a longer period would give rise to significantly greater guarantee costs. Some of these guarantee costs have been partially matched through the purchase of negative inflation hedges and limited price indexation bonds.
Key risk factors
(a) Insurance risk
(i) Mortality risk
For contracts providing death benefits, higher mortality rates would lead to an increase in claims costs. For annuity contracts the Group is exposed to the risk that mortality experience is lower than assumed. Lower than expected mortality would require payments to be made for longer and increase the cost of benefits provided. The Group regularly reviews its mortality experience and industry projections of longevity and adjusts the valuation and pricing assumptions accordingly.
The Group is exposed to mortality risk on protection and annuity business. For protection products, the Group has entered into reinsurance arrangements to mitigate this risk and provide financing. Annuity contracts are not generally reinsured externally.
(ii) Persistency
At early durations, lapses and surrenders are likely to result in a loss to the Group, as the acquisition costs associated with the contract would not have been recovered from product margins. Some contracts include surrender penalties to mitigate this risk.
At later durations, once the acquisition costs have been recouped, the effect of lapses and surrenders depends upon the relationship between the exit benefit, if any, and the liability for that contract. Exit benefits are not generally guaranteed and the Group has some discretion in determining the amount of the payment. As a result, the effect on profit at later duration is expected to be broadly neutral.
Following the adoption of PS06/14 in 2006, as described in Note 37, the persistency assumption for non-participating protection business allows for the expected pattern of persistency, adjusted to incorporate a margin for adverse deviation. Previously, the liabilities were established so that they were sufficient to cover the more onerous of the two scenarios, in which the policies either remain in force until maturity, or discontinue at the valuation date.
There is no persistency risk exposure for annuities in payment. These contracts do not provide a lapse or surrender option.
(iii) Morbidity rates
The cost of health related claims depends on both the incidence of policyholders becoming ill and the duration over which they remain ill. Higher than expected incidence and duration would increase costs over the level currently assumed in the calculation of liabilities.
(iv) Expense variances
Higher expenses and/or expense inflation will tend to increase the value of the reserves required. The Group is exposed to the risk that its liabilities are not sufficient to cover future expenses.
(v) Geographic concentrations of risk
Insurance risk may be concentrated in geographic regions, altering the risk profile of the Group. The most significant exposure of this type arises for the group protection business, where a single event could result in a large number of related claims. To reduce the overall exposure, current contracts include an ‘event limit’ which caps the total liability. Additionally, excess of loss reinsurance arrangements further mitigate the exposure.
(vi) Epidemics
The spread of an epidemic could cause large aggregate claims across the Group’s portfolio. Quota share reinsurance contracts are used to manage this risk.
(vii) Accumulation of risks
There is limited potential for single incidents to give rise to a large number of claims across the different contract types written by the Group. In particular, there is little significant overlap between the long term and short term insurance business written by the Group. However, there are potentially material correlations of insurance risk with other types of risk exposure. These correlations are difficult to estimate though they would tend to be more acute as the underlying risk scenarios become more extreme. An example of the accumulation of risk is the correlation between reinsurer credit risk with mortality and morbidity exposures.
(b) Market risk
Investment of the assets backing the Group liabilities reflects the nature of the liabilities being supported. For non-participating business the objective is to maximise profits, while ensuring stability, by closely matching the cash flows of assets and liabilities. To achieve this matching, the strategy is to invest in fixed income securities of appropriate maturity dates.
Interest rate risk is reduced by managing the duration and maturity structure of each investment portfolio in relation to the estimated duration of the liabilities it supports. A number of derivatives are held to enable the matching of asset and liability to mitigate further exposure to interest rate movements, in particular to limit the exposure to any options and guarantees in contracts.
In addition, the exposure to these risks is allowed for in the actuarial valuation of liabilities under these contracts.
(c) Sensitivity analysis
The table below shows the impact on pre-tax profit and equity, net of reinsurance, under each sensitivity scenario for the non-participating business written in the non profit part of the UK LTF.
| Impact
on pre-tax profit net of reinsurance 2006 £m |
Impact
on equity net of reinsurance 2006 £m |
|
|---|---|---|
| Sensitivity test | ||
| Market interest rate increase of 1% | (139) | (98) |
| Market interest rate decrease of 1% | 237 | 166 |
| Reduction in the mortality rates for annuitants of 5% | (234) | (164) |
| Protection claims increasing by 5% | (73) | (51) |
| Increase in expenses of 10% | (59) | (41) |
| Increase in lapse rates of 10% | (25) | (18) |
| Decrease in lapse rates of 10% | 27 | 19 |
- In calculating the alternative values, all other assumptions are left unchanged. In practice, items of the Group’s experience may be correlated.
- The Group seeks to actively manage its asset and liability position. A change in market conditions would lead to changes in the asset allocation or charging structure which may have a more significant impact on the value of the liabilities. The analysis also ignores any second order effects of the assumption change, including the potential impact on the Group asset and liability position and any second order tax effects.
- The sensitivity of the profit to changes in assumptions may not be linear as implied by these results. They should not be extrapolated to changes of a much larger order.
- The change in market interest rate test assumes a 100 basis point change in the gross redemption yields on UK life and pensions fixed interest securities together with a 100 basis point change in the real yields on variable securities. Valuation interest rates move in line with market yields adjusted to allow for the impact of FSA regulations.
Participating contracts
Participating contracts are supported by the with-profits part of the Society LTF. They offer policyholders the possibility of the payment of benefits in addition to those guaranteed by the contract. The amount and timing of the additional benefits (usually called bonuses) are contractually at the discretion of the Group.
Policyholders and shareholders share in the risks and returns of the with-profits part of the Society LTF. The return to shareholders on virtually all participating products is in the form of a transfer to shareholders’ equity, which is analogous to a dividend from the Society LTF and is dependent upon the bonuses credited or declared on policies in that year. The bonuses are broadly based on historic and current rates of return on equity, property and fixed income securities, as well as expectations of future investment returns.
UK life and pensions allocates discretionary increases to benefits on its participating contracts in one or both of regular and final bonus form. These bonuses are set in accordance with the principles outlined in the Group’s PPFM for the management of the with–profits part of the Society LTF. These principles include:
- The with-profits part of the Society LTF will be managed with the objective of ensuring that its assets are sufficient to meet its liabilities without the need for additional capital.
- With-profits policies have no expectation of any distribution from the with-profits part of the Society LTF’s inherited estate. The inherited estate is the excess of assets held within the Society LTF over and above the amount required to meet liabilities, including those which arise from the regulatory duty to treat customers fairly in setting discretionary benefits.
- Bonus rates will be smoothed so that some of the short term fluctuations in the value of the investments of the with-profits part of the Society LTF and the business results achieved in the with-profits part of the UK LTF are not immediately reflected in payments under with-profits policies.
Some older participating contracts include a guaranteed minimum rate of roll up of the policyholder’s fund up to the date of retirement or maturity.
The nature of the participating contracts written in the with-profits part of the Society LTF is that more emphasis can be placed on investing to maximise future investment returns. This results in a broader range of investments being held within the fund.
With-profits bonds
These contracts provide an investment return to the policyholder which is determined by the attribution of regular and final bonuses over the duration of the contract. In addition, the contracts provide a death benefit, typically of 101% of the value of units allocated to the policyholder.
Pension contracts
The Group has sold pension contracts containing guaranteed annuity options which expose the Group to both interest rate and longevity risk. The market consistent value of these guarantees carried in the balance sheet is £75m (2005: £130m).
Deferred annuity contracts
The Group has written some deferred annuity contracts which have guaranteed minimum pensions. These options expose the Group to interest rate risk as the cost would be expected to increase with interest rates. These guarantees only apply with respect to premiums already received. The market consistent value of these guarantees carried in the balance sheet is £114m (2005: £120m).
Key risk factors
The insurance and market risk exposures for participating business are largely the same as those discussed for non-participating contracts. The notable differences in the operation of these contracts are discussed below.
(a) Insurance risk
(i) Persistency
At early durations, the nature of the persistency risks on with-profits business is largely the same as for non-participating business and is influenced mainly by the ability to recover acquisition costs from product margins. At later durations, there is less scope for withdrawal to result in a loss for the Group as these contracts typically provide explicit allowances for market conditions. Allowance for future withdrawals is made in the assessment of participating contract liabilities. The Group is generally exposed to the risk that future withdrawals are lower than assumed, resulting in higher future guarantee costs.
(b) Market risk
The financial risk exposure for participating contracts is different from that for non-participating business. Greater emphasis is placed on investing to maximise future investment returns rather than matching assets to liabilities. This results in holding significant equity and property investments. Lower investment returns increase the costs associated with maturity and investment guarantees provided on these contracts.
These risks are managed by maintaining capital sufficient to cover the consequences of mismatch under a number of adverse scenarios and by the use of derivatives. In addition, different investment strategies are followed for assets backing policyholder asset shares and assets backing other participating liabilities and surplus. The former include significant equity and property holdings, whilst the latter are invested largely in fixed interest securities and are managed so as to provide a partial hedge to movements in fixed interest yields.
The methodology used to calculate the liabilities for participating contracts makes allowance for the possibility of adverse changes in investment markets on a basis consistent with the market cost of hedging the guarantees provided. The methodology also makes allowance for the cost of future discretionary benefits, guarantees and options.
The value of future discretionary benefits depends on the return achieved on assets backing these contracts. The asset mix varies with investment conditions reflecting the Group’s investment policy, which aims to optimise returns to policyholders over time whilst limiting capital requirements for this business.
The distribution of surplus to shareholders depends upon the bonuses declared within the fund. Typically, bonus rates are set with regard to investment returns, although the Group has some discretion setting rates and would normally smooth bonuses over time. The volatility of investment returns could have both a favourable and unfavourable impact on the fund’s capital position and its ability to pay bonuses. If future investment conditions were less favourable than anticipated, the lower bonus levels resulting would also reduce future distributions to shareholders.
However, business which is written in the with-profits part of the Society LTF is managed to be self-supporting. The unallocated divisible surplus in the fund would normally be expected to absorb the impact of these investment risks. Only in extreme scenarios, where shareholders were required to provide capital support to the with-profits part of the Society LTF, would these risks affect equity.
The Group’s approach to setting bonus rates is designed to treat customers fairly. The approach is set out in the Society’s PPFM for the with-profits part of the Society LTF. In addition, bonus declarations are also affected by FSA regulations relating to Treating Customers Fairly (TCF), which limit the discretion available when setting bonus rates. The Group’s approach to setting bonuses and meeting the FSA’s TCF regulations may increase the Group’s exposure to market risk should the ability to cut bonuses, during periods when investment returns are poor, be reduced.
(c) Sensitivity analysis
Future bonuses influence both the current capital requirements of the fund and future profitability.
The unallocated divisible surplus is accounted for as a liability. This represents the assets within the with-profits part of the Society LTF, in excess of the realistic liabilities, which are available to pay future bonuses. Changes in the key underlying variables will affect the value of the assets and liabilities in the fund. The level of unallocated divisible surplus will be adjusted to allow for changes in assets and liabilities and, as a result, there would normally be no impact on shareholders’ equity.
In extreme scenarios shareholders may be called upon to provide additional capital support to the fund. However, the Group has discretion in the management actions it can take with regard to participating policies to mitigate the extent of any additional support required.
Participating policyholders and shareholders share in all surplus arising in the with-profits part of the Society LTF. 10% of the surplus is normally distributed to shareholders. The risk factors detailed in this section could affect future distributions of surplus and shareholders’ 10% share thereof.
Linked contracts
For linked contracts (investment and insurance), there is a direct link between the investments and the obligations. Linked business is written in both the Society LTF and in the LTF of Legal & General Assurance (Pensions Management) Limited. The financial risk on these contracts is borne by the policyholders. The Group is, therefore, not exposed to any market risk, currency risk and credit risk for these contracts. The Group’s primary exposure to financial risk from these contracts is the risk of volatility in asset management fees due to the impact of interest rate and market price movements on the fair value of the assets held in the linked funds, on which investment management fees are based. The Group is also exposed to the risk of an expense overrun should the market depress the level of charges which could be imposed, although for some contracts the Group has discretion over the level of management charges levied.
International life and pensions
Legal & General America (LGA)
The principal products written by LGA are individual term assurance, universal life insurance and smaller blocks of deferred and immediate annuities.
The individual term assurances provide death benefits over the medium to long term. The contracts have level premiums for an initial period with premiums increasing annually thereafter. During the initial period, there is generally an option to convert the contract to a universal life contract. After the initial period, the premium rates are not guaranteed, but cannot exceed the age related guaranteed premium.
Reinsurance is used to reduce the insurance risk on this portfolio and manage liquidity risks, through the reinsurance commission received under quota share arrangements. Reinsurance and securitisation are used to provide regulatory solvency relief (including relief from regulation Triple X). These practices lead to the establishment of reinsurance assets on the Group’s balance sheet.
The universal life insurance and deferred annuities provide a savings element. In addition to the savings component, the universal life contract provides substantial death benefits over the medium to long term. The savings element has a guaranteed minimum growth rate. LGA has exposure to loss in the event that interest rates decrease and it is unable to earn enough on the underlying assets to cover the guaranteed rate. LGA is also exposed to loss should interest rates increase, as the underlying market value of assets will generally fall without a change in the surrender value. The reserves for universal life and deferred annuities totalled $766m and $272m respectively at 31 December 2006 (2005: $799m and $277m respectively). The guaranteed interest rates associated with those reserves ranged from 1.5% to 5.5%, with the majority of the policies having a 4% guaranteed rate (the same rates applied in 2005).
The deferred annuity contracts also contain a provision that, at maturity, a policyholder may move the account value into an immediate annuity, at rates which are either those currently in effect, or rates guaranteed in the contract. The other annuity contracts have similar risks to those in the UK.
Legal & General Netherlands (LGN)
LGN principally writes non-participating individual unit linked savings, protection and annuity business. The unit linked savings business generally includes an element of exposure to mortality risk. The individual term assurances provide death benefits over the medium to long term. Reinsurance is used to reduce the share of insurance risk.
The annuity contracts have similar risks to those in the UK; however, the majority of annuity business has a term of three years or less.
Legal & General France (LGF)
LGF writes a range of long term insurance and investment business through its subsidiaries. The principal products written are life assurance and pensions savings, group protection, annuities and open ended investment vehicles.
The group protection business consists of group term assurance, renewable on an annual basis, sickness and disability, and medical expenses assurance. The group sickness and disability and medical expenses policies integrate with the social security benefits providing a level of top-up to those benefits. Reinsurance is used to manage exposure to large individual and group claims.
The annuity contracts have similar risks to those in the UK.
General insurance
LGI offers a range of general insurance contracts, including:
- Household contracts. These provide cover in respect of policyholders’ homes, investment properties, contents, personal belongings and incidental liabilities which they may incur as a property owner, occupier or private individual. Exposure is normally limited to the rebuilding cost of the home, the replacement cost of belongings and a policy limit in respect of liability claims. LGI uses reinsurance to manage the exposure to an accumulation of claims arising from any one incident, usually severe weather. The catastrophe cover reinsures LGI for losses between £30m and £250m (2005: £25m and £225m) for a single weather event.
- Motor insurance. These contracts provide cover in respect of customers’ private cars and their liability to third parties in respect of damage to property and injury. Exposure is normally limited to the replacement value of the vehicle, and a policy limit in respect of third party property damage. Exposure to third party bodily injury is unlimited in accordance with statutory requirements.
- Accident, sickness and unemployment (ASU). These contracts provide cover in respect of continuing payment liabilities incurred by customers when they are unable to work as a result of accident, sickness or unemployment. They protect predominantly mortgage payments. Exposure is limited to the monthly payment level selected by the customer sufficient to cover the payment and associated costs, up to the duration limit specified in the policy.
- Healthcare. These contracts are primarily private medical insurance, which compensate customers for the costs of eligible medical consultations, diagnostic tests, in—patient, day care and outpatient treatment up to the limits specified in the policy. They are mainly exposed to the underlying incidence of morbidity, medical claims inflation and advances in medical treatments.
- Domestic mortgage indemnity (DMI). These contracts (primarily in run-off) protect a mortgage lender should an insured property be repossessed and subsequently sold at a loss. Since 1993, the contract has included a maximum period of cover of 10 years, and a cap on the maximum claim. For business accepted prior to 1993, cover is unlimited and lasts until the insured property is remortgaged or redeemed.
Key risk factors
Weather events
Significant weather events such as windstorms, and coastal and river floods can lead to significant claims.
The insurance of properties which are concentrated in high risk areas, or an above average market share in a particular region, can give rise to a concentration of insurance risk. This risk is managed by ensuring that the risk acceptance policy, terms and premiums both reflect the expected claim cost associated with the location and avoid adverse selection. Additionally, exposure and competitor activity is monitored by location to ensure that there is a geographic spread of business. Catastrophe reinsurance cover reduces the Group’s exposure to concentrations of risk. The level of catastrophe cover is selected to manage the risk of an event which would be expected to occur once in every 200 years.
Subsidence
The incidence of subsidence can have a significant impact on the level of claims on household policies. The Group’s underwriting and reinsurance strategy mitigates the exposure to concentrations of risk arising from geographic location or adverse selection.
Unlimited motor claims
A single motor policy can result in major multiple liability claims in extreme scenarios. To mitigate this risk, accident excess of loss reinsurance is in place for claims in excess of £1m (2005: £1m).
Sensitivity analysis
The table below shows material sensitivities for the General insurance business on pre-tax profit and equity, net of reinsurance.
| Impact on pre-tax profit net of reinsurance 2006 £m |
Impact on equity net of reinsurance 2006 £m |
|
|---|---|---|
| Sensitivity test | ||
| Single storm event with 1 in 200 year probability | (30) | (21) |
| Subsidence event — worst claim ratio in last 30 years | (37) | (26) |
| Repeat of 1990 recession on ASU/DMI/household accounts | (52) | (36) |
| 5% decrease in overall claims ration | 15 | 11 |
| 5% surplus over claims liabilities | 7 | 5 |
For any single event with claims in excess of £30m but less than £250m, the ultimate cost to the Group would be £38.5m. The impact of a 1 in 500 year event would exceed the catastrophe cover by approximately £100m.